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March 1, 2013

How to Capitalize on Shale Gas Trend: A Top Manager’s Favorite Plays

A comprehensive study of the economics of shale has determined the nationwide mass of rock-based natural gas deposits has got legs on it that can carry U.S. industry and consumers for another three decades.

“Welcome to the party,” T. Rowe Price portfolio manager Tim Parker (left) told AdvisorOne in an interview. “Because this is something that has pretty wide implications across the whole economy.”

The University of Texas study, released Thursday, was widely reported as vindicating shale gas boosters who long claimed that natural gas could be cost-effectively extracted from the subterranean rock.

To get an investment perspective on what this new era of energy abundance means, AdvisorOne reached out to Parker, who manages the T. Rowe Price New Era Fund (PRNEX), one of the oldest natural resource funds, established in 1969.

According to Parker, technology and economics have combined to create opportunity in shale. The key technological innovations were hydraulic fracturing and horizontal drilling. The former, also known as fracking, involves blasting shale rock with water, sand and chemicals to release gas; the latter is a way to recover an even greater volume of gas.

“If you do vertical, hang a left, go 6,000 feet, fracture that…there’s a lot of gas in there,” Parker says.

Economically, when a glut of natural gas brought the price down to $2 per million British thermal units (BTU) one and two years ago, it was hard for all but the lowest-cost producers to survive.

But natural gas today is priced at about $3.50 per BTU, a short distance from the assumption of the University of Texas study that found shale drilling to be profitable at $4 per BTU.

That makes shale gas an attractive investment, according to Parker, since “supply is flattening out and…gas is at a cyclical low,” meaning that a spike in price over the coming years would enhance investment returns.

So, how to capitalize on a long-term growth trend the university study says won’t plateau till 2040? Parker offers some “rules of the road.”

“First, try to be seasonally aware,” he says. “Natural gas isn’t as strong in spring and fall…People get nervous about falling prices, so that’s usually the best time to buy…Hold your fire for now—wait till spring.

“Second, find a lower-cost producer; if prices stay low you want them to survive.”

“The Marcellus Shale is the biggest story,” he said. “It’s half the size of Pennsylvania. At $3.50, some of these wells are economic. In Haynesville [in Texas and Louisiana], drilling doesn’t make money at $3.50, but it sure does at $4.50.”

Back to Marcellus, Parker says, “my ideal companies have more than one asset, preferably a gas and liquid asset,” referring to companies that develop oil fields as well. “Range would be a good example of that. Gas is unpredictable, and you don’t want to be left holding the bag if winter didn’t show up.”

Another angle is what Parker refers to as “rimshots”—investments that benefit indirectly through lower production costs because of plentiful, cheap natural gas.

“If I’m a mini-mill, a lot of my cost is energy,” he said, “Cheaper gas is a wind in my sail.”

Parker cites LyondellBasell (LYB) as an example of a chemical company that has built a lot of capacity along the gas-rich Gulf of Mexico and thus enjoys an advantage over competitors.

Steel companies like Nucor (NUE) similarly benefit over international competitors with much higher energy costs.

Another way to capitalize on the growth in shale gas production is by buying the companies that get the gas from Point A to Point B: “A lot of these shales are in areas where we had infrastructure [like Texas],” he said. “But some, like in Pennsylvania, there wasn’t infrastructure.”

In this regard, Parker favorably cites the energy infrastructure assets of Williams Cos. (WMB), but also puts in a good word for master limited partnerships like Kinder Morgan Energy Partners (KMP) that his fund can’t invest in for tax reasons but which he says “a financial advisor looking for yield” might find of interest.

Broadly speaking, natural gas is just a component of Parker’s New Era Fund, whose mandate is investment in diversified natural resources, but that doesn’t stop Parker from overweighting a sector he believes has greater potential.

“I’m tilted long natural gas, but I still own metals and forest products,” he says. Oil and gas make up about 50% of the natural resources sector, but New Era is about 55% oil and gas, and within that subsector, Parker tilts more heavily to gas than oil because, he says, gas is out of favor.

Parker sees oil as starting to develop a glut, as occurred in recent years with natural gas, and cites a World War II-era law preventing the export of oil as both an impediment to increased profitability of oil companies and as a boon to U.S. refiners like Valero (VLO) and Phillips 66 (PSX), which get crude oil cheaper because of this U.S. bottleneck. Parker warns this is an area where one wants to be highly selective. “I try to own lower-cost producers or special situations like Hess Corp. (HES),” he says.

The T. Rowe Price manager is unconcerned about some of the controversy swirling around shale gas production, particularly about its environmental impact.

New York state, unlike Pennsylvania, has not benefited from its share of the vast Marcellus shale because of a ban on hydraulic fracturing.

Concerns about leaking tanks are “good, honest real concerns,” Parker says. “You need to have strong operators and strong regulations.” But he says experience has shown that fracking is safe.

Barring a bad cement job, “that oil and gas is not going to get into the aquifers—if so, it would already have happened—unless there’s a break in the well.”

“Biogenic [naturally occurring] gas can get into an aquifer,” he adds. “I can show you some creeks where you can set the water on fire where there’s no drilling in sight.”

But New York’s taking its shale out of play is simply not a factor, he adds.

“In a world that has plenty of gas, we don’t need New York’s gas now. I feel sorry for the New York landowners. Maybe 20 years from now New Yorkers will feel different” about the safety and opportunity in shale, Parker says.